Editor’s Note:  This article is the copyrighted property of The FBB Group, LTD.® and is published by The M&A Source with written consent of The FBB Group, LTD.®

Cash flow means different things to different people.  Or, put a different way, different entities will use different proxies for cash flow depending on what matters most to them.  For an individual who owns a business, cash flow can mean “discretionary earnings” or what the total return of cash and benefits is to the owner.  To an institutional buyer (i.e. a Private Equity Group), a more relevant depiction of cash flow would be “Earnings Before Interest Taxes Depreciation and Amortization” or EBITDA.  And to lenders, the more relevant definition of cash flow might be “Cash available for debt service.”  The differences between these numbers used for cash flow come down to what matters to the beholder.  For this reason, it is important that a seller keeps these motivations in mind when they think about “recasting” financial statements with add backs when they’re in the process of selling.  Some add backs can be misleading, but others are legitimate and should be included to create accurate adjusted financials.

The following is a list of common add backs that we here at Gen Cap America frequently consider legitimate for us to reach an accurate understanding of what EBITDA would look like post transaction.

Adjustment to Owner’s Compensation:  It’s not uncommon for owners of private companies to pay themselves a higher than market salary and/or bonus.  There’s nothing wrong with this practice, and frankly, it’s one of the many benefits of being a business owner.  That said, it’s also reasonable to expect a private equity group to evaluate this amount when thinking about what they would pay a new (or current) executive going forward.  So, while an owner can certainly add back some of their compensation, an owner should refrain from adding back the whole amount, as some portion of that will need to be used to pay a competitive salary to a future manager or the current CEO going forward.

Personal Expenses:  Add backs that fall into this category would be those personal expenses that a private equity group could reasonably expect not to incur post transaction.  These might include cell phone bills, club dues, or stipends to family members not working in the business. The owner’s vehicle expenses and travel expenses could also be potential add backs in this category; however, owners should be careful to consider whether the vehicle expenses or travel truly provided no benefit to the company or at least could reasonably be expected not to be paid in the future without any impact to the company.

Severance: If the company paid a consequential severance payment to a departing employee, it would be reasonable for this to be included as an add-back, as this would qualify as a “one-time” expense, assuming it truly was a rare occurrence that shouldn’t be expected on a recurring basis.  Lawsuit settlements could be considered in the same way, assuming the settlement was a single, isolated incident.

Charitable Donations:  Oftentimes owners are active members in their community and therefore want to make charitable contributions to nonprofit organizations within their community.   They might do this out of altruism and/or to secure a corporate tax deduction.  In any case, if an owner believes that a potential buyer could forgo these gifts without any impact on the business, they can adjust this expense to positively impact EBITDA.

Those are four of the more legitimate add back categories we look at regularly; however, it is also worth mentioning that in over 25 years of doing deals, Gen Cap has seen its fair share of “not so” valid add backs.  Some of these might include:

Annual “one-time” expenses:  If a “one-time” expense happens every year, it’s not a “one-time” expense.  It’s recurring.  To use the example of severance payments mentioned above, it’s reasonable to consider a severance payment an isolated payment.  However, if the company has to pay these packages out to departing employees on a regular basis, it’s not a legitimate add back.  It’s the price of doing business.

Advertising:  Sometimes owners can look back at their advertising and/or marketing spends and consider elements of that spend “a waste” or non-essential, and therefore, they consider this an item worthy of an add back, since it could be cut from the budget in future years without any negative impact to sales.  This may be true, but these types of judgements are often difficult to determine.

BOTTOM LINE:  Add backs should be those expenses that a new owner could reasonably expect not to incur going forward with limited impact to the business.  It is also worth mentioning that while a seller could consider thousands of potential add backs when selling their business, it’s best to limit these to “larger” items.  Because buyers look at these with such acute scrutiny, listing too many add backs would only bog down an already complicated process.  And lastly, sellers should always do these calculations BEFORE bringing their business to market.  During a negotiation is the wrong time to bring up add backs and their validity.